How the Fed Works

The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.

Here's how it works. The Fed purchases securities from a bank (or securities dealer) and pays for the securities by adding a credit to the bank's reserve (or to the dealer's account) for the amount purchased. The bank has to keep a percentage of these new funds in reserve, but can lend the excess money to another bank in the federal funds market. This increases the amount of money in the banking system and lowers the federal funds rate. This ultimately stimulates the economy by increasing business and consumer spending because banks have more money to lend and interest rates are lowered.

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When the Fed wants to decrease the money supply, it sells securities. That transaction deducts the purchase amount from the bank's reserve (or the dealer's account). This reduces the amount of money the bank has to lend in the federal funds market and increases the federal funds rate. This move ultimately slows the economy down by decreasing the amount of money banks have to loan, which increases interest rates and typically reduces consumer and business spending.

These decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four rotating members from the other eleven Reserve Banks. This committee has eight meetings per year to discuss and direct the monetary policy. Additional emergency meetings are called when needed. The FOMC specifies either a quantity of reserves to be purchased or sold or a specific change in the federal funds rate. (The federal funds rate is the interest rate at which banks lend reserves to other banks.)